This article refers to a paper written by Benjamin N. Roth – you can find it here
This paper answers a very interesting question: when would a philanthropist choose to invest in a social enterprise rather than give it a grant? This question is important for “blended finance” practitioners who can, in theory, allocate capital with required returns that range anywhere from -100% (a grant) up to market rates of return. My employer CDC Group (soon to be British International Investment) is piloting a facility which can allocate pure grants in a few cases (although only in a minority of cases because the facility is required to make some overall return).
The paper starts by saying it will examine two propositions:
1. Impact investors can help social enterprises reach financial sustainability and no longer rely on a constant stream of philanthropic subsidies.
2. Impact investors can help social enterprises reach a larger scale and increase their impact.
It arrives at two conclusions that, at least on my first reading, seemed to miss the primary function of impact investing. But it turns out that reflects the direction that Roth has chosen to come at the problem from, and seen from another direction his model fits perfectly well with how impact investors intuitively think about what they do.
Roth approaches the problem by considering a philanthropist who wishes to support a social enterprise, and asks when an investment is preferable to a grant. His first point is that because investing comes with the ability to require returns, impact investors are able to extract money from social enterprises, which is superior to a grant when recycling that money into something new would be more impactful than leaving it where it is, for the enterprise to ‘spend’ it on cutting prices [1].
The second result is harder to swallow. Because investors are able to extract and reallocate money in impactful ways, this gives enterprises a reason to generate profits to return to the investor, even if doing so is detrimental to their mission as judged by the people they intend to benefit. In this way impact investors “empower the entrepreneur to exploit a profitable opportunity” in way that grant givers would not encourage. An example, Husk Power, is used to show how impact investors might encourage Husk to expand and increase profits to the detriment of Husk’s mission, and Roth describes that “improving” upon a donation.
I expect impact investors do not think of themselves as creating value by reducing the positive impact of social enterprises but that’s because most investors are not comparing the positive impact of the businesses that they invest in against a hypothetical grant-financed alternative, whereas Roth’s model does. In his model investors can achieve an overall improvement by reducing the impact of enterprise A relative to a grant financed counterfactual by generating more profit, which can then be reallocated to enterprise B (or to some other worthy purpose).
These two advantages of investments over grants omit what is, to my mind, the more obvious function of impact investing in helping social enterprises reach a larger scale and increase their impact, which is to provide the upfront financing needed to create a socially beneficial and commercially sustainable enterprise, where that social benefit is large enough to justify the “cost” of a sub-commerical investment but not large enough to justify grant financing.
So what’s going on? We need to dig into the model behind these conclusions.
The model
A firm needs some start-up investment (normalised to 1). Over its lifetime it generates revenues, pays costs (which are solely a function of the quantity of output sold) and either receives or returns money to the investor (denoted as ‘R’ in the model, either positive or negative). An impact investor can choose to either extract returns or provide more money (in addition to the initial 1), but a grant-giver effectively denies themselves the ability to extract returns.
The model hinges on something that I think does not get enough attention in debates about impact investing and public subsidies for private investment (blended finance): passthrough from required returns and grants to prices. One objection to policies aimed at “mobilizing private finance” is that the capitalists are suspected to benefit from that and not consumers.
In Roth’s model the less is extracted (or the more granted) the more the enterprise can afford to reduce its prices. We can interpret “cutting prices” in this model as a stand in for anything that both reduces profits and increases customers’ welfare, such as improving quality or accessibility. Because we are talking about a social enterprise not a profit maximiser, its managers are assumed to be mission oriented (like the philanthropist) and care about the welfare of customers, and reducing prices increases welfare.
A digression: how realistic is that? There are some parallels with what I know of DFI investing — for example, when DFIs invest in infrastructure projects and can influence pricing, they will price the services so that revenues only cover a low return requirement and if there are opportunities to make more money they will not take them.
Otherwise pricing is delegated to the managers of firms, some of whom might be mission-oriented and trying to keep prices low. I don’t know how often we see a passthrough from the interest rate we charge on debt to the pricing of goods and services sold. Some examples might be providing cheap or local currency credit to banks for on-lending to SMEs, and perhaps off-grid solar vendors. If we are equity investors alongside the project sponsor, then presumably sometimes we both might receive lower returns because the business is forgoing opportunities to increase profits but I would be surprised if that’s often an explicit part of the investment thesis and business plan. More often I think we expect the firms we invest in to have a positive social impact as profit maximisers, but to require our finance because local capital markets are not willing to provide finance on the terms they need, for various reasons (risk appetite, return requirements etc.)
Back to the model: a parameter captures the investor’s cost of capital, which because we are talking about a mission-oriented philanthropist should be interpreted as their valuation of whatever other good things they can do with the money they extract from their investments. Combine this with the idea that there is a direct line between the nature of an enterprise’s financing and its social benefits, via prices, and it’s straightforward to see why a philanthropist will prefer an investment to a grant only when their “cost of capital” exceeds the social impact generated by not requiring returns [2].
So, what is going on?
Roth’s paper reaches conclusions which, in my view, miss the primary function of impact investing because (I think) its analysis concerns whether (and when) investments are better than grants taking upfront financing as given. The paper does not dwell on the question of whether to provide upfront financing in the first place.
Some firms need many millions in upfront financing before they reach commerical sustainability. It would be daft to grant finance a $4bn solar park. If there are projects like that, which cannot obtain finance on suitable terms from commerical investors, impact investors can help social enterprises reach a larger scale and increase their impact by providing finance on terms and in quantities not available from commerical investors, where grant financing would not be justified.
This is entirely consistent with Roth’s results — those enterprises where a philanthropist would be prepared to meet upfront financing needs if they can make some sort of a return, but would not want to finance upfront costs with a grant, are precisely those identified as better suited to investment in his model [3]. Some of those enterprises might generate profits in ways that are somewhat detrimental, seen from a purely altruistic mission-oriented point of view, in line with Roth’s second result.
If Roth’s model was used to analyse the decision of whether to meet the upfront financing needs of a set of enterprises, that differ both in terms of the sums they require and the positive social impact they could generate, it would reveal the existence of socially beneficial enterprises that require impact investors because their social benefits are not large enough, relative to upfront financing needs, to justify a grant. Roth normalises the size of upfront financing to 1, but this set of enterprises might be easier to see if upfront financing requirements were allowed to vary [4]. The model has everything needed to explain the fact that impact investments in private enterprises tend to be much larger than grants given to private enterprises. It is also consistent with the point I make in the paper Are Development Finance Institutions Good Value for Money? that the “impact per dollar” required for an investment to represent a cost-effective use of aid budgets is a fraction of that required from a grant. In fact the approach I take there, comparing investments against a cash transfer, is remarkably similar to Roth’s comparison of extracting returns versus giving a grant that enables the enterprise to reduce prices (which amounts to the same thing as a cash transfer).
Summing up
Some of those most profound and powerful mechanisms in economics sound rather banal when stated in plain language (externalities, transcation costs etc.) and Roth’s insight that investments are better than grants when the money you extract from an enterprise is worth more to you than the outcomes of leaving it there, risks sounding like a truism. But I think Roth really has put his finger on the fundamental reason why someone who wants to do good might sometimes want to require financial returns.
I found the paper very hard to digest at first because I found it so hard to square with my prior understanding of what impact investing is all about. But once I spotted that I had been focused on how impact investors achieve good things by providing finance to enterprises that both commerical investors and grant-givers would not, whereas Roth puts that initial decision in the background, everything fell into place. To my mind, I think as presently written Roth’s paper overlooks an important function of impact investors and should therefore moderate its language in some places, but it would be a relatively simple thing to rejig the presentation to bring the “extensive margin” of projects that need impact investment to the forefront.
Roth’s paper left me really wanting to read some empirical investigations into the connection between financing and pricing. Is there evidence that social enterprises (or perhaps profit maximising firms in competitive markets) use concessional finance to reduce prices (or improve quality and accessibility)? When is that more or less likely? How can concessional finance be designed to avoid capture in excess private returns? These are absolutely crucial questions in debates around subsidising (or “de-risking”) private investment — who benefits? The capitalists or the customers?
Some questions
There are a few things I’d like to understand better about how the results rest on assumptions made in the model:
1. The firm has increasing marginal costs. It might be more natural to think of firms with some fixed cost and then constant marginal variable costs, at least over some range. This seems important because in Roth’s model the firm sometimes chooses to set a low price at which it breaks even, leaving unsatisfied demand so that it must ration output. The firm chooses not to raise prices to cover the cost of expanding output, when marginal costs are increasing, because the reduction in consumer surplus across customers outweighs the benefit of additional customers being able to purchase the output. But I am still not sure I really understand why the costs outweigh the benefits so that it’s not socially optimal to raise prices and serve more customers if the demand is there. Are there negative externalities or something? Does this mean standard profit maximising firms in competitive markets with increasing marginal costs are not socially optimal, once we place more weight on the welfare of their customers than their investors, and society would be better off if firms cut prices and reduced volumes and rationed output?
2. At one point Roth describes how it is trivial that the financier must value money in their bank account more highly than money in the enterprise’s customers’ pockets at the margin, otherwise they would give away all their money to the firm to reduce its prices put money in those pockets. But what about longevity? A financier could give away all their money to reduce prices and make people better off, but their funds will be quickly exhausted. Plus, if all your philanthropic money is doing is a straight pass through to consumers, why not fund actual cash transfers rather than muck about with social enterprises? The philanthropist’s decision in Roth’s model is fairly static — would the results change if duration was introduced? The first proposition Roth sets out to examine talks of a reliance on “constant stream of philanthropic subsidies.”
3. More of a comment than a question. I would guess that most investors would presume that receiving grant financing will affect the effort managers will put into generating sales and cutting costs. I think Roth notes that possibility but that’s not in the model. If included, it would introduce another potential reason to prefer investments to grants.
4. In an extension to the model, Roth considers the differences between equity and debt. I would like to know if “debt … does not change the entrepreneur’s incentive to pursue profit on the margin. In contrast, equity depresses the entrepreneur’s incentive to pursue profit and results in him placing a relatively higher weight on the firm’s mission” (page 24) is true in reality? Does that give us another reason to invest more equity and less debt? The usual reason is that debt makes entrepreneurs risk averse, equity absorbs risk.
5. Another extension that might be interesting would be to explore the implications of stochastic outcomes. In Roth’s model, returns for investors come at the cost of higher prices and lower welfare. But impact investors sometimes structure concessional finance as repayable grants, where repayments are conditioned on commerical performance. Does that mean prices are chosen first then uncertain revenues are realised, second? That sequence might imply that repayments come at the expense of the entrepreneur’s retained profits, not higher prices and lower welfare. It would be interesting to explore whether conditionally repayable grants avoid giving the enterprise a reason to raise profits in socially detrimental ways, as happens in Roth’s model.
Note: This post was greatly improved by personal correspondence with Ben Roth, who very kindly responded to an early draft. This does not imply he agrees with everything in this later draft. Ben has a bunch of other papers that are relevant to people in the impact investing / development finance business, and I strongly recommend you check them out here.
[1] The owners and managers of social enterprises might also use a grant to increase their own incomes, which could be mitigated by an investor extracting returns from the enterprise.
[2] In practice, it is not at all easy for would-be investors or grant-givers to gauge the relative magnitudes of social impact to take these decisions. We have some guidelines at CDC to help us decide when potential social benefits are large enough to justify more concessional finance. More generally, I suspect that investments tend to be chosen as soon as there perceived to be a sufficiently high chance of the enterprise reaching profitability.
[3] I am using the phrase “upfront financing needs” to avoid confusion created by the unfortunate twin meanings of the word “investment” (real and financial) otherwise I would be writing these enterprises need investments to finance upfront investments.
[4] More generally, rather than just looking at variation in financing needs and potential impact across enterprises, we might also consider variation within enterprises as the managers of each enterprise possess a set of feasible business models with differing impact and upfront cost profiles, some of which might be supported by purely commercial investors, some by returns-seeking but impact-oriented investors, and some by DFIs and others willing to deviate significantly from market net return requirements (possibly including some grant element). DFIs are often additional because their finance allows enterprises to do something different to what commerical investors would have supported. Having different potential business models is captured in Roth’s model, in an abstract way, by being able to set different prices.
